Guest Commentary: Katharina Pistor

Illiquidity versus Insolvency – A False Dichotomy

Katharina Pistor is Walter E. Meyer Research Professor in Law & Social Problems and Michael I. Sovern Professor of Law at Columbia Law School.

There is a tendency in finance to view (il)liquidity and (in)solvency as conceptually distinct problems, capable of being described and regulated independently of one another. Nowhere is this more clearly the case than in banking regulation and Bagehot’s dictum to lend freely to illiquid, but not insolvent, banks. In reality, however, liquidity and solvency are inextricably linked as suggested by the papers presented at the conference “Finance between Liquidity and Insolvency” held at Goethe University’s House of Finance and co-sponsored by the Research Center SAFE, the Max-Planck-Gesellschaft and the Alexander von Humboldt Stiftung on 11/12 December 2015.

The solvency of the banking system requires the relaxation of banks’ liquidity constraints by central banks as a matter of day-to-day practice. Central banks also play a critical role as liquidity backstops during periods of financial instability. They have broadened their reach by offering liquidity even to non-bank intermediaries at least if they can offer adequate collateral. The effect of these and other interventions is to insulate financial intermediaries from the application of general insolvency rules.

Whether banks should be exempt from the application of general insolvency rules is of course an important question. On one level, the post Lehman answer to this question has been a resounding “no”. On another level, the answer has been to develop more tailored substitutes for general insolvency laws in the form of bank resolution regimes, reflective of the particular challenges of resolving failing banks.

Neither of these answers, however, speaks directly to the question of where to draw the line, much less whether such line-drawing exercises go to the core of governing inherently instable financial systems. The new solution for bank resolution, bail-ins that force certain creditors and shareholders to foot the bill of failure amply illustrates this. The success of bail-ins hinges on the availability of bail-in-able capital and thus requires management of the liability side of banks’ capital long before illiquidity becomes an issue.

To complicate matters even further, finance is no longer all about banks. With the rise of shadow banking practices, many of the challenges of bank governance faced over the centuries are now replicated at the level of non-bank financial intermediaries and at the intersection between financial institutions and markets. Whether institutions or markets are more or less deserving of protection from binding liquidity constraints has been a recurring theme in debates about bail-in, closeout netting protocols, and access to central bank lending. However, they have rarely been addressed as a unifying theme for governing finance in all its manifestations. This conference filled this gap by including the rise of shadow payment systems, clearing and settlement systems and accounting rules in the discussion.

The discussions at the conference suggested that we need a clearer concept of liquidity as distinct from volume or turnover. In essence, liquidity stands for leveraged entities’ access to lender and dealer of last resort facilities in times of distress. This conception captures the ambiguities of modern finance as a system that stands at the intersection of public and private: a rule bound system the survival of which depends on relaxing these rules from time to time. It follows that finance is inherently political.